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Few Problems Have Emerged Yet in Retail Real Estate Finance

The financial sector continues to digest the weekend bailout of Freddie Mac and Fannie Mae. Yet in spite of the continued run of bad news and strain on the financial system, investors, lenders, banks and others continue to have a largely positive view of retail real estate. That view is bulwarked by the fact that defaults and delinquencies on retail real estate remain muted. There have been few blowups or problem mortgages to work through yet. Furthermore, the credit crunch has brought a return to sanity among investors in retail real estate properties.

“There remains capital for good real estate transactions,” said Dan Gilbert, executive vice president of New York City-based NorthStar Realty Finance Corp., during this week’s Capital Markets Conference sponsored by ICSC and NAIOP in New York City. “And that’s capital from top-tier providers,” not from the kind of “fast money” investors that flooded the industry in recent years largely betting on cap rate compression rather than looking at real estate metrics. “Fundamental real estate investment is returning,” added Mark Wilsmann, managing director of New York City-based MetLife Real Estate Investments.

To be sure, the environment today is much different than it was in 2005, 2006 or 2007. The volume of investment sales is down massively. The commercial mortgage-backed securities (CMBS) market remains at a standstill. Experts are skeptical that the market will match the heady days of its recent run for many years. “We know now that $250 billion a year for CMBS is too big,” said J. Christopher Hoeffel, senior managing director of New York City-based JPMorgan Chase. “But it should be a $100 billion to $125 billion a year business.”

The more appropriate comparison is to 2004 or earlier, which, many point out, wasn’t exactly a bad year for retail real estate or commercial real estate finance.

The biggest issue going forward is that the industry needs to continue to take stock of just how aggressive things got in the 2005 to 2007 period and eventually deal with the repercussions. Aggressive pricing, long interest only periods, shoddy underwriting and net operating income rental projections that now look like pure fantasy all combined to produce financing packages that will create problems. In reality, retail property values have dropped about 10 to 15 percent from the peak. Combine that with rising vacancies and it’s clear that some borrowers will eventually have issues paying down debt. Moreover, lenders have become much more stringent about the debt they are giving out. That will make it hard to refinance. As a result, the question of distressed debt did hang over the conference.

“The banks I don’t think have recognized the issues yet,” said Art Rendak, vice president with Oak Brook, Ill.-based Inland Mortgage Capital Corp., during another session. “I think there will be a lot more product to sell very shortly. A lot of the stuff that’s selling [now] is at death’s door. [When it gets] to an 80 percent occupied shopping center, that’s our thing.”

The borrowers that will survive will be those that can adjust to the new market. That means putting more equity forward and, in most cases, signing recourse.

“It comes down to: if you are dealing with good clients and you’ve got recourse, you are going to have to pony up and restructure the loan,” said Mike Higgins, managing director with New York City-based CIBC. “That’s what’s going to happen, maybe you will have to bring in mezz debt. On some of those larger deals, that’s where the problem is—non-recourse financing. The guy really doesn’t own the property anymore. You’ve got to foreclose and sell it.”

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